When the monetary authority begins to tighten policy by raising interest rates, it does so for two reasons:

–the domestic economy is giving signs of overheating, that is, of growing at an unsustainably high rate, and needs to be reined back in before runaway inflation results

–too much money is sloshing around in the system, and finding its way into more and more speculative investments.

For stock market investors, the tightening process implies two things:

–the rate of profit growth in business cycle-sensitive industries is peaking and will begin to decline, and

–playing the greater fool theory by holding crazily speculative investments will no longer work as excess money is siphoned out of the economy.

However the Fed proceeds, the second effect will surely happen, I believe. But the US economy can scarcely be said to be overheating. Despite this–and the Fed’s promised vigilance to prevent a meaningful slowdown in economic activity, I think all stocks–and cyclical ones in particular–will be affected.

Why?

…because the Fed tapping on the brakes lessens/removes the ability of investors to dream of a possible openended future cyclically driven upsurge in profit growth. Whether specifically aimed at this or not, Fed action will have the effect of tempering Wall Street’s avaricious dreams.

What about dollar weakness, EU growth, China…?

In every cycle there are special factors. They don’t change the overall tone of the market, though.

The main effect of a weaker dollar and stronger EU economic performance will be to increase the attractiveness of EU stocks, and of US names–principally in Staples and IT–with large EU exposure. Look for the stocks with big holes in December and March quarterly income statements.

As for China, who knows? My guess is that the Chinese economy won’t deteriorate further from here. But the main China story , as I see it, will be the country’s gradual shift to consumer demand-drive growth along with the substitution of local products for imports. To me, both aspects suggest that well-known US, EU and Japanese China plays won’t regain their former glory.

My bottom line: the shift from cyclical to secular may be more modest than usual this time, but it will still be there. A more conservative mindset argues against further price earnings multiple expansion for the market. So future market gains will depend entirely on earnings growth. The larger immediate effect will likely be in the loss of market support for very speculative stocks.